Revisiting the New Markets Tax Credit

The new markets tax credit (NMTC)
was enacted under the Community Renewal Tax Relief Act
of 2000, P.L. 106-554, and was incorporated into the
Internal Revenue Code as Sec. 45D. The NMTC aims to
encourage capital investment in economically depressed
areas by private investors in exchange for federal
income tax credits. Treasury has used data collected
over the past 10 years to analyze the program’s
overall effectiveness in stimulating the local economy
and promoting job growth. The results have shown that
the NMTC has been effective in spurring investment in
real estate development, but it has failed to attract
a significant amount of investment in other types of
businesses.

Earlier this year, the Obama
administration introduced the Startup America
initiative, a national campaign aimed at increasing
U.S. worldwide competitiveness in high-growth,
job-creating industries, such as clean energy,
medicine, advanced manufacturing, and information
technology. As a part of the plan, President Barack
Obama proposed to expand the NMTC to encourage
private-sector investment in startups and small
businesses operating in lower-income communities. To
that end, Treasury has proposed revisions to the NMTC
regulations, primarily to make the program more
attractive to investors in non–real estate businesses
in low-income communities. The proposed regulations
were published in a notice of proposed rulemaking
(REG-101826-11) issued in June 2011.

Legal Framework of the NMTC

Sec.
45D(a) provides that taxpayers who hold a qualified
equity investment (QEI) can claim an NMTC equal to 39%
of the original investment amount in a qualified
community development entity (QCDE). Taxpayers claim
the credit over a seven-year period at a rate of 5% of
the investment amount for each of the first three
years and 6% for each of the remaining four years.
Sec. 45D(h) requires taxpayers to reduce their basis
in the QEI by the amount of the credit claimed.
Taxpayers that redeem their investment during the
seven-year period are subject to recapture of the
credit plus interest.

A QEI is defined in Sec.
45D(b) as any investment in a QCDE if:

The investment is acquired at its original issue
solely in exchange for cash;

Substantially all of the cash is used by the
QCDE to make qualified low-income community
investments (QLICIs); and

The
investment is designated by the QCDE as a QEI on its
books and records using any reasonable method.

Sec. 45D(c) defines a QCDE as any domestic
corporation or partnership whose primary mission is
serving, or providing investment capital for,
low-income communities or low-income persons. The
entity must be accountable to the residents of the
low-income communities through residents’
representation on its board. The IRS must also certify
the entity as a QCDE.

A QLICI, as defined by
Sec. 45D(d), is:

Any capital or
equity investment in, or loan to, any qualified
active low-income community business (QALICB);

A purchase from another community development
entity of any loan made by such entity that is a
QLICI;

Financial counseling and
certain other services to businesses located in, and
residents of, low-income communities; or

Any equity investment in, or loan to, any other
QCDE.

A QALICB is any corporation
(including a nonprofit corporation) or partnership
that:

Derives at least 50% of its total
gross income from the active conduct of a qualified
business within any low-income community;

Uses a substantial portion of its tangible
property and performs a substantial portion of its
services in a low-income community; and

Holds less than 5% of the unadjusted basis of
such property as collectibles (other than those held
for sale in the ordinary course of business) or
nonqualified financial property (as defined in Sec.
1397C(e) for enterprise zone businesses—generally
stocks, bonds, notes, partnership interests, certain
other securities and contracts, and similar assets).

A qualified business, including a
QALICB, includes any business not specifically
excluded by Secs. 45D(d) and 1397C(d). A qualified
business does not include one that primarily develops
or holds intangibles for sale or license, or one
operating a golf course, country club, or certain
other recreational or gaming facilities. It can be a
farming activity, but only if the basis of its
business assets and value of leased property combined
do not exceed $500,000. The rental of nonresidential
real property is generally a qualified business if the
property is located in a low-income community and is
substantially improved. A QALICB can be a sole
proprietorship or portion of a business that would
otherwise qualify as a QALICB if separately
incorporated.

A low-income community is described
in Sec. 45D(e) as a census tract in which the poverty
rate is at least 20% or the median family income does
not exceed 80% of the state’s or metropolitan area’s
median family income, with special rules for areas not
in census tracts, tracts with low populations, those
in rural counties with high population migration, and
certain other targeted populations.

The
nationally allocable dollar limit for the NMTC is set
for each calendar year by Sec. 45D(f). For 2011, the
maximum available credit is $3.5 billion. Treasury
allocates that amount among applying QCDEs. The
deadline for submitting allocation applications for
the 2011 credit was July 27, 2011. Recipients of
allocations of the credit are generally announced
early the following year.

At the time of this
writing, Congress has not extended the credit beyond
2011. However, the Obama administration’s 2012 budget
proposes to extend the NMTC through 2012, with an
allocation of $5 billion.

Implementation of the NMTC Program

The Community Development Financial Institutions
(CDFI) Fund, an agency within Treasury, administers
the NMTC program. The mission of the CDFI Fund is to
“expand the capacity of financial institutions to
provide credit, capital, and financial services to
underserved populations and communities in the Unites
States.” Under this mission, the CDFI Fund directly
invests in and supports community development
financial institutions working in underserved
communities. Besides the NMTC, the CDFI Fund also
oversees the Bank Enterprise Award and Native
Initiatives programs.

Since the NMTC program’s
inception, the CDFI Fund has awarded a total of $29.5
billion in tax credit authority to 594 QCDEs (U.S.
Department of the Treasury, Community Development
Financial Institutions Fund, 2010 New Markets Tax
Credit Program Allocations 23 (July 24,
2011)). The CDFI Fund announced in August 2011 that it
had received 314 applications from QCDEs requesting
$26.6 billion in credit allocations for 2011—more than
seven times the amount available. In 2010, 99 QCDEs
were selected from among 250 applicants to receive the
$3.5 billion in available credit for the year (id.).
The types of organizations receiving allocations of
the credit include CDFIs, nonprofit organizations,
government-controlled entities, banks, publicly traded
institutions, real estate development companies, and
minority-owned or controlled companies. The eligible
investment activities carried out by these
organizations include loans to, or equity investment
in, businesses and real estate projects,
capitalization of other community development entities
to fund other NMTC-eligible activities, and purchase
of NMTC-eligible loans originated by other QCDEs.

The CDFI Fund reported that more than 98% of NMTC
recipients have invested in low-income communities
through preferential rates and terms on loans, such as
below-market interest rates, lower origination fees,
and longer-than-standard periods of interest-only
payments (id. at 28–29). However, only 35% of the NMTC
investment has been in non–real estate businesses, and
much of this portion has gone to support real
estate–related projects (REG-101826-11).

Promoting Non–Real Estate Business
Investment

The proposed regulations revise the
reinvestment rules to increase the program’s ability
to benefit non–real estate businesses in low-income
communities. QCDEs are required by Sec. 45D(b) to
invest substantially all of the cash they receive in
QLICIs. Regs. Sec. 1.45D-1(d)(2) currently requires
amounts received as returns on QLICIs within the
seven-year qualification period (including repayments
of principal from amortized loans) to be reinvested in
QLICIs within a 12-month period. The preamble to the
proposed regulations notes that this continuous
reinvestment requirement “makes it difficult for
[QCDEs] to provide working capital and equipment loans
to non-real estate businesses because these loans are
ordinarily amortizing loans with a term of five years
or less.”

The proposed regulations offer an
alternative reinvestment rule for QCDEs that make
QLICIs in non–real estate businesses. The proposed
regulations define a non–real estate QALICB as any
QALICB whose predominant business activity “does not
include the development (including construction of new
facilities and rehabilitation/enhancement of existing
facilities), management, or leasing of real estate.” A
predominant business activity is one that generates
more than 50% of the business’s gross income.
Furthermore, the purpose of the money invested in the
business cannot be connected to the development,
management, or leasing of real estate.

As an
alternative to the current reinvestment rule, if a
QCDE makes a QLICI in a non–real estate business and
receives a payment of, or for, capital, equity, or
principal from that business during the seven-year
credit period, the QCDE may reinvest the money in an
unrelated certified CDFI that is recognized as a
community development entity for purposes of the NMTC.
The reinvestment into the CDFI must occur within 30
days from the date of receipt of the payment for the
monies to be treated as continuously invested.

However, the total amount a QCDE may reinvest in a
CDFI for purposes of the continuously invested
requirement is limited. The total amount reinvested in
a CDFI cannot exceed an escalating percentage of the
maximum aggregate portion of the non–real estate QEI
within the seven-year credit period: 15% in year 2,
30% in year 3, 50% in year 4, and 85% in years 5 and
6. QCDEs are not required to reinvest payments
received in the seventh credit year.

Looking Forward

The IRS appears
committed to increasing the ability of the NMTC
program to provide access to credit in low-income
communities. The revisions to the regulations provide
an alternative means of reinvesting returns during the
seven-year credit period and appear to be a promising
step in that direction.

EditorNotes

Mark Cook is a partner at SingerLewak LLP in
Irvine, CA.

The editor would like to offer a
special thanks to Christian J. Burgos, J.D., LL.M.,
for his assistance with this column.

For additional information about these items,
contact Mr. Cook at (949) 261-8600, ext. 2143, or mcook@singerlewak.com.

Unless otherwise noted,
contributors are members of or associated with
SingerLewak LLP.

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